June 3, 2024 | By Dorian Hunt, Head of Renewables
If you claim a federal tax credit on a renewable energy project in the U.S., it’s sometimes the case that the amount of federal tax credit can be increased by virtue of containing a sufficient quantity of “domestic content”. What is domestic content? It’s not the contents of your home, so put down that Hummel figurine: it’s of no use in this context. Domestic content in this context is the steel and iron and equipment that constitutes a renewable energy installation.
On May 16, 2024, the IRS and Treasury released Notice 2024-41,1 which (among other things) provides a new elective safe harbor that may be applied when determining whether a solar photovoltaic, land-based wind, or battery energy storage project might be able to enjoy an increased domestic content credit. For those project types, this guidance is a welcome change as previously-issued guidance on domestic content was often difficult to interpret and implement in practice.
Background
The federal law commonly known as the Inflation Reduction Act of 2022 (the “IRA”), amended §§ 45 and 48 to provide a domestic content bonus credit amount (the “Domestic Content Adder”) for certain qualified facilities or energy projects placed in service after December 31, 2022. In addition, the IRA added new §§ 45Y and 48E, which also include a Domestic Content Adder for certain investments in qualified facilities or energy storage technologies placed in service after December 31, 2024. Projects that fulfill the requirements for the Domestic Content Adder are eligible for an increase in the amount of investment tax credit (“ITC”) or production tax credit (“PTC”) that may be available in connection with the project. Specifically, for the production tax credit under §§ 45 or 45Y, the Domestic Content Adder increases the applicable credit rate per kWh by 10 percent (not 10 percentage points); for projects under §§ 48 or 48E, the Domestic Content Adder is an increase of 10 percentage points to the applicable credit rate.
The increased credit amounts for projects using domestic content are part of a larger continuum of federal tax credit programs intended to incentivize a revitalization of manufacturing in the U.S. The domestic content incentives encourage developers to source domestically-manufactured steel, iron and equipment. Likewise, direct manufacturing incentives such as 48C (note: round 2 concept papers are due on June 21 – Qualifying Advanced Energy Project Credit (48C) Program | Department of Energy) and 45X (see my article on the proposed regulations) are working to make that domestically-sourced equipment available to project developers.
In May of 2023, the Internal Revenue Service (the “IRS”) and the Department of Treasury (“Treasury”) issued Notice 2023-38,2 which provides guidance on meeting the requirements necessary for a taxpayer to be eligible for the Domestic Content Adder. In that notice, the IRS and Treasury set forth a two-prong approach in determining whether the Domestic Content Adder is available. Generally speaking, a project satisfies the domestic content requirement if it meets – (i) the steel or iron requirement; and (ii) the manufactured product requirement.
For purposes of satisfying the steel or iron requirement, any steel or iron that is a component of an applicable project is treated as produced in the U.S. if all manufacturing processes (other than metallurgical processes involving refinement of steel additives) with respect to the steel or iron take place in the U.S. This requirement applies to project components made primarily of steel or iron and are structural in function (such as rebar), but not to any steel or iron contained in manufactured project components or subcomponents. Thus, for example, bolts, screws, and similar items used in a manufactured project component that are made primarily of steel or iron are not subject to the strict steel or iron requirement.
With regard to manufactured products, the IRA provides they are deemed domestically produced if not less than a certain percentage of the total cost of the manufactured product is mined, produced, or manufactured in the U.S. (the “Domestic Cost Percentage”). For this purpose, a manufactured product is considered to be produced in the U.S. if – (i) all of the manufacturing processes for the product take place in the U.S.; and (ii) all of the manufactured components of the manufactured product are of U.S. origin. A manufactured product component is considered to be of U.S. origin if it is manufactured in the U.S. regardless of the origin of its subcomponents.
Unfortunately, the Domestic Cost Percentage as described in Notice 2023-38 can be difficult to implement in practice because it requires a project owner to get significant detail from vendors (e.g., solar panel providers) around direct labor and material costs involved in manufacturing, given that the calculation relies only on these costs rather than the price paid by the developer. In practice, vendors are often reluctant to share that data as it would reveal their profit margins to their customers and other proprietary information.
As an example, assume that a developer has a project in River City, Iowa that consists of two manufactured products D and F. D is 100% made in the USA and F was manufactured on Mars (which could introduce a significant opportunity to capitalize shipping costs into ITC eligible basis). The price paid by the developer for D is $100 and the price paid for F is $122. In this case, if those prices paid reflected only the direct labor and material costs of the vendors, then those vendors might have a going concern issue. Putting existential concerns to the side for a moment, if we lay out the math, let’s assume that the developer got amazing deals on this equipment and then calculated its Domestic Content Percentage as $100/($100 + $122) =~ 45%. This is great news if this project began construction before January 1, 2025, and thus would need to only demonstrate a 40% Domestic Content Percentage3 or higher to benefit from the Domestic Content Adder. Now, shifting toward a slightly more realistic set of facts, let’s assume that $122 reflects only the direct labor and materials costs (that is, the data we need to calculate the Domestic Cost Percentage described in Notice 2023-38) of the Mars operation in the manufacture of item F. We can further assume the developer paid $201 for item F. Write that number down on a small slip of paper and then throw it in the trash, it doesn’t matter for this analysis. However, further assume that unlike the Mars operation, the manufacturer of D isn’t playing ball and won’t share their direct labor and material costs. The manufacturer of D just says pay me $100. So, this presents a conundrum – what is a developer to do?
As the developer community moved to adapt to the framework of Notice 2023-38, we saw the evolution of multi-layer consulting engagements requiring digital clean rooms, data escrows and other quasi cloak-and-dagger convolutions I hadn’t expected to see in this aspect of my mild-mannered tax consulting life. We also saw attempts to guess what the vendor profit margins might be to establish a position around domestic content. In our example above, if the profit margin and indirect labor portion of D’s cost for item D were 10%, that would imply a direct labor and materials cost of $90 which would give us $90/($90 + $122) = 42%. That math would suggest that we’re still OK – unless our guess is wrong and the vendor of D’s profit margin was actually 20%. Friend, you might want to close your eyes to a situation you do not wish to acknowledge, but we’ve got trouble in River City because your Domestic Content Percentage is now $80/($80 + $122) = 39.5%.
As a side note, projects attempting to take advantage of direct pay opportunities under Section 6417 that begin construction (within the meaning of IRS Notice 2013-29 et. al.) during 2024 have a domestic content requirement (notwithstanding the exceptions of 48(a)(10)(D)(i)(I)) to enjoy the full level of incentive. For further discussion of 6417, read my article here.
Notice 2024-41
On May 16, 2024, the IRS and Treasury released Notice 2024-41, which (among other things) provides a new elective safe harbor (the “Elective Safe Harbor”) that may be applied in determining whether the Domestic Content Adder is available for photovoltaic solar, onshore wind, and battery energy storage projects. The Elective Safe Harbor provides a prescribed method to calculate the fulfillment of the Domestic Cost Percentage without access to vendor direct labor and materials data. Thus, the Elective Safe Harbor simplifies the manufactured product calculation by generally requiring only the calculation of a simple sum of figures derived from a provided table. If a taxpayer elects to apply the Elective Safe Harbor, the taxpayer must then use the Elective Safe Harbor’s classifications of components and cost percentages instead of the direct costs of the manufacturer to determine whether the Domestic Cost Percentage rule is satisfied.
The Elective Safe Harbor applies to both the steel or iron requirement and the manufactured products requirement for a project with respect to which a taxpayer elects to have it apply. Under the terms of the safe harbor, the classifications and cost percentages provided in the notice will be accepted by the IRS for the identified manufactured products and manufactured product components for purposes of determining compliance with the steel or iron requirement and calculating the Domestic Cost Percentage, provided all other requirements in Notice 2023-38 are met. That is, Notice 2024-41 doesn’t override Notice 2023-38, but they are rather to be viewed as companion documents. Notice 2024-41 can provide an easier path to the Domestic Content Adder in some circumstances.
If we see the forest from the trees, however, two key concepts transcend both Notices: 1) if a project doesn’t meet the steel and iron requirements then it doesn’t qualify for domestic content and 2) when determining the extent to which a manufactured product can count toward the Domestic Content Percentage, if any one of that manufactured product’s components is not U.S.-sourced, then you don’t get to count the production/manufacturing costs incurred to turn those components into a manufactured product (i.e., the production/manufacturing costs are only counted if all of a manufactured product’s sub-components are U.S. sourced).
The Elective Safe Harbor allows taxpayers to elect to use the classifications of components and cost percentages provided in Notice 2024-41to determine whether the adjusted percentage rule in Notice 2023-38 is satisfied. In most cases, to determine the Domestic Cost Percentage using the Elective Safe Harbor, a taxpayer must refer to Table 1 provided in Notice 2024-41 that describes its applicable project and add up the assigned cost percentages for each listed U.S. manufactured product and U.S. component (as described in section 3.03(2)(b) of Notice 2023-38) of the project. This total value is the Domestic Cost Percentage for purposes of the Elective Safe Harbor. It can get a little more complicated when you have co-located solar and BESS or foreign and domestic sourced manufactured products of the same type (for example, photovoltaic modules), but still far less complicated than implementing the requirements as outlined in Notice 2023-38.
The Elective Safe Harbor will likely prove beneficial to taxpayers in determining whether the Domestic Content Adder is available with respect to a project. However, there are some limitations inherent in the Elective Safe Harbor. First, a taxpayer cannot rely on the Elective Safe Harbor for only some part of a project. Instead, the safe harbor is an “all or nothing” approach. Thus, taxpayers that elect to use the Elective Safe Harbor must use the classifications and cost percentages provided in Notice 2024-41 when applying the adjusted percentage rule and may not use different methods or cherry-pick the manufacturer’s actual direct labor and material costs for certain items, even if doing so would yield a more favorable result for those specific manufactured products.
If you have a project that contains a manufactured product that is not listed in Table 1 of Notice 2024-41, then you can pretend, for the purposes of the Domestic Cost Percentage that this manufactured product just does not exist. For example, let’s say you had a ground mount (tracking) solar photovoltaic project as listed in Table 1 of Notice 2024-41 that consisted of the items listed in the Table, but also a foreign-sourced SCADA system. Following the machinations of Notice 2023-38, one interpretation implies that you’d have to do the potentially hard work of figuring out its underlying cost detail, as necessary. Under the New Elective Safe Harbor, this SCADA system is not a factor in the calculation of the Domestic Content Percentage. So, it’s easy to see situations where you might be able to claim, for example, an investment tax credit and a corresponding Domestic Content Adder for a piece of equipment that wasn’t additive or detrimental to the Domestic Content Percentage. This deemed completeness of Table 1 cuts both ways, though – if you have, for example, a PV module that doesn’t include backrails, you would lose 5.3% (as derived from page 15, Table 1 of Notice 2024-41) in your Domestic Content Percentage. The maximum possible Domestic Content Percentage contribution from the photovoltaic modules drops from 66.3% to 61% with the total possible value for the ground mount (tracking) applicable project component dropping from 100% to 94.7%.
With the release of the proposed regulations for the upcoming technology agnostic federal credit regime (Federal Register :: Section 45Y Clean Electricity Production Credit and Section 48E Clean Electricity Investment Credit), we are reminded that the 40% threshold we’ve been using for our examples is not static. If we begin construction in 2025 the threshold is generally 45%, 50% for 2026 and 55% for years after 2026. If we want to get a feel for how that escalation decreases the possible domestic content qualifying compositions over time, we can do some combinatorics. Looking at the Solar PV ground mount (tracking) column from Table 1, we can see there are 25 items total in the list (including production costs) so if we’re looking at about 35.5 million possible combinations. There are about 20 million combinations that lead to a 40% or greater sum, about 18 million for 45% or greater, about 17 million for 50%, and about 15 million for 55%. The universe of realistic combinations is much smaller, but this math demonstrates that our assumptions need to evolve as the Domestic Content thresholds phase in.
Conclusion
Notice 2024-41 provides welcome relief to taxpayers in making what otherwise was a difficult determination. Unfortunately, there may be a variety of reasons that a particular project may not qualify for the Elective Safe Harbor. At a minimum, however, the Election Safe Harbor eliminates the need to question vendors regarding data they may be unwilling or unable to provide. This alone means that more projects should (or at least should attempt) to qualify for the Domestic Content Adder. As always, the first question should be about steel and iron because if a project doesn’t satisfy that requirement, it’s not worth looking any further. Then, if a project fits in the new Elective Safe Harbor’s Table 1, it’s likely worth pursuing that calculation. If we don’t fit, we’re back to navigating Notice 2023-38.
Overall, we expect the tax equity and third-party tax credit markets to welcome the certainty provided by Notice 2024-41. We also expect for projects that are able to take advantage of the Elective Safe Harbor that the review of the Domestic Content Adder will be less labor intensive. While not entirely free of complexity, the simplified methodology set forth for solar photovoltaic, land-based wind, or battery energy storage projects should reduce uncertainty in credit pricing for live transactions and help developers more easily assess the expected value for pipeline and under development projects.
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